November 1991
Vol 15 No 1
That's an old sales cliche that's been around for a long time, but it still holds true when things start to look bleak – and in many parts of the country that's how they're starting to look. Even though the FED has released tons of money into the system and has brought down the costs of credit to the banks to levels not seen in years, the housing markets in many areas are slumping. The recession has made people more cautious. They're not buying. This has caused ripples that are being felt throughout the economy. Let's face it; outside the software industry, most of the wealth that's been produced in the 'hot' areas of the country has come from soaring house prices. When housing slumps, so do lots of other things.
Look at all the things that go into a new house. Pipes, windows, cement, plywood, insulation, steel, hardware, cabinets, appliances, heating/cooling and control systems, formica, water heaters, telephones, carpeting, tile, furnishings, paint, wallpaper, etc. For most of these items, housing is the biggest customer. About 95% of all the money earned by the real estate brokerage industry comes from house sales. As go sales, so goes building and land development. And the mortgage loan business.
A slump in housing sales can throw more people into financial distress than any other single industry downturn. With rising prices, speculators could feed a negative cash flow property, then deduct their losses from current taxable income – and defer taxes on the appreciating equity. In the end they expected to realize a handsome profit. Now, prices are starting to drift downward in areas where real estate prices have traditionally been the strongest. Just to add insult to injury, their own personal income is threatened by the same factors that have caused the housing slump. It's a scary time for people with families to support.
'BITE THE BULLET', DON'T 'BITE THE DUST' . . .
Instead of bemoaning your fate, starting today, focus your mind on ways to improve your situation. Let me tell you a little story. 31 years ago, the Millers were riding high holding 2nd mortgages on 4 houses which provided a cash flow that effectively doubled my take home pay from wages. The mortgage servicing company filed bankruptcy. All payments stopped. We were given a choice of losing everything or taking over 1st mortgages on 4 empty houses spread from Florida to Texas to California.
Our payments were suddenly twice my wages. The whole family had to pitch in. Here are some of the things we did to try to recover:
1. Established a bare-bones budget to stretch earnings as far as possible.
2. Substituted covered dish suppers, picnics and camping out for parties.
3. Sold off alt extra vehicles and 'toys' to lower expenses and raise cash.
4. To generate cash flow income, I started selling used cars, opened a TV dealership and repair shop, moonlighted as a musician, made small loans.
5. Hired real estate agents to repair, rent up and manage my empty houses.
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Sure, it was a major and traumatic adjustment in our life style, but it changed us from being victims tossed about on the waves of fortune. We made these sacrifices in order to survive and start over. You can't win if you stop trying to get ahead and quit when things turn out badly. Only by taking a hard look at the things YOU did wrong which precipitated your bad luck, then laying plans to remedy them, can you find the silver lining lurking in the dark clouds. We all learn a lot more from our mistakes than from our successes. Would you have lost if you'd bought a different type of property? Negotiated better prices or terms? Avoided commercial lenders? Been a better manager? Had bigger/better cash reserves? Invested in a different area? Been more knowledgeable? How can you improve?
It will do little good to waste time, energy and emotion feeling sorry for yourself. The sooner you go to work rebuilding, the less it will cost you emotionally and financially. The recovery experience can lay the foundation for a bright future if you use what you learn the next time you start back up the ladder. But beware, the world changes and you'll have to change with it. The future holds promise as well as pitfalls that you should give some consideration to if you're going to avoid more losses.
ALL SHIPS RISE AND FALL WITH THE TIDE . . .
There are vast sea changes taking place in the world today that can't fail to affect the future of every American. Europe is undergoing political and economic transformation which will divert billions of dollars from our economy. Spain's stock market has been zooming because of the EEC's effect on it's economy. Sanctions are being lifted in South Africa.
The Pacific is also extremely dynamic now. Hong Kong money is flowing away from China. Korea, Singapore, Taipei, Thailand are growing capital markets. Japan is shaking off it's own economic slump. These countries will be formidable competitors for American markets. Closer to home, Mexico is competing for American jobs. The current sorry state of American public school education has cost us our edge. Many employers are finding it cheaper to use foreign labor to assemble equipment, then ship it back home for sale rather than to try and train our high school graduates who haven't developed efficient work habits or marketable skills.
Government at all levels is running out of money. At the Federal level, it will manipulate credit to get what it needs through borrowing or simply increase taxes. At state and local level we can expect higher sales, use, property and franchise taxes. As property values (and property taxes) are driven higher and higher because of inflation, fewer and fewer people will be able to afford to buy because of lower family income. That will depress land sales, construction, finance, brokerage incomes, service sector wages, in affected areas. That's the bad news.
The good news is that America has the capital, trained work force, updated manufacturing capacity, technological resources, food-growing and timber-growing capability, transportation networks, and mineral resources to enable it to continue on as the biggest economy in the world IF GOVERNMENT JUST LETS US GET ON WITH THE JOB. That's a pretty big IF. That means that money has to be diverted away from social safety nets and placed into the credit markets where it can be used to expand economic opportunities for those who can and will use it productively. And the only people who can do that is the American voter, PAC, statesman. Hopefully we'll do it soon.
Assuming the foregoing premises are reasonable, what should we be doing now? Any kind of credit crunch drives interest rates higher, and correspondingly, the value of any low yield fixed rate mortgages lower. As taxes are increased in an effort to give the dollar some sort of credibility in the international credit markets, those same mortgages will yield lower and lower net after-tax income to the holders. At the same time, falling income levels will cause loan defaults to rise.
If government reverts to its tried and true technique of throwing caution to the winds and trying to inflate its way out of debt, the purchasing power of the payment received will be diminished. So mortgage investors will be trading off after tax yield in return for more defaults and loss of purchasing power. I think I'd liquidate my mortgages and use the cash received to buy something that would be less vulnerable.
As credit tightens, fewer and fewer people will be able to buy shelter. They'll have to rent it. Except for those areas where rents are controlled, demand will push rental income yields higher even as house prices are dropping due to the lack of demand FOR THOSE WHO HAVE TO LIQUIDATE THEM. At that point, the cash from the sale of the mortgages can be used to buy rental income streams at bargain prices. And the lack of mortgage financing caused by the credit crunch will make owners more amenable to 'creative financing'. Those who are restarting their equity building programs will find this to be a lucrative market in the credit crunch scenario above.
In lieu of actually discounting mortgages in the market and using cash to buy single family houses, the mortgages themselves can be used as a form of 'private currency'. To the distressed home owner who needs cash to pay bills, they offer something which either can provide income, or which (s)he can discount for cash. This way, any discount the mortgage holder might have to suffer can be passed along to the distressed former home owner.
By substituting rents for interest income, mortgage investors can realize tax sheltered yields which should compare favorably to after tax interest yields, but at the cost of management effort. That's the bad news. The good news is that good managers will be able to increase their yields through rent raises and management efficiencies. Their income stream is indefinite while their old mortgage yields would sooner or later stop as the mortgages became fully amortized. But what about the property value?
In a downturn caused by higher interest rates, property values would also suffer. But, as a buyer in the market, that's exactly the result you should he waiting for. Lower values, mean lower property taxes and insurance costs, lower purchase prices, easier terms. The only time an investor should welcome rising values is when (s)he's either getting out of the market or never expects to invest in it again. Doesn't it make more sense to buy low with high rents as a % of value than to buy high with lower rents as a % of price? In uncertain times, it might be better to have a steady income stream than to have a large net worth without that income.
Let's look at an inflationary scenario. Plenty of money chasing too few tangible goods. Real estate has always been the beneficiary of inflation more than any other investment medium. Rising incomes will bring buyers hack in droves, driving up prices and gains. Being able to buy in a down market and sell in an up market is just the scenario I envision for the balance of this century as events unfold. Those who buy AND sell 'right' will he able to profit from both economic troughs and peaks if they're ready.
Market timing is half the battle. Driving a hard bargain is the other half.
NEGOTIATION MEANS NEVER HAVING TO SAY I'M SORRY . . .
One of the principal reasons that people get caught in a downturn is that they don't know how to negotiate price and financial terms. Part of their problem is that they just don't understand the true motives of the sellers. Another problem is that they don't have enough grasp of ways in which financing can add cash flow and value to a property. By combining ways to elicit true motivation with a broad array of financial arrangements, transactions can be made that would otherwise fall by the wayside.
Half the battle lies in getting to the true problems of the sellers. Don't expect them to reveal the truth to you, a stranger. You have to get to know them, and let them know you. You have to engender TRUST that you won't look for ways to cheat them once you're in possession of all the facts concerning their true motivation. On the other hand, there's no harm in letting them know that you too have certain needs.
Your first need should be to be able to buy a property at a price and on terms that will enable you to hold it for the long term in the event of any economic upheaval. Your second need is that your investment provide reasonable cash flow over the holding period. Remember, the home owner occupant has received some of his profit in the form of life style and use of the property. Your only profit will be in rents and capital gains, so you've got to have the reasonable expectation of profit to offset the trouble and risks of ownership. Lastly, you don't want to risk any other property you've acquired previously just to make one more deal.
Ideally, you're looking for owners who are selling for non-profit reasons. Job change. Divorce. House/neighborhood doesn't meet their needs. Personal problems with the neighbors. Kid problems. By finding ways to help them move, you'll buy their property. You might find them a replacement house, hire a moving van and helpers, create an income stream with a second mortgage and take over the payments on their existing 1st, lease the property long term at below market rates, or buy an Option from them.
When people have a specific minimum amount of cash they absolutely must have in order to solve their problem, you can 'down stream' the problem to the person who'd receive the money and see if you couldn't resolve things better there. In one instance, a recent up-tick in interest rates caused all of a builder's qualified customers' loans to fall out. By convincing him to accept their existing homes at high retail trade in value, they were able to qualify at the new interest rates and complete their purchases.
He paid off his construction debt, received full payment for the land beneath the new houses, realized a portion of the profit he'd been expecting. We were able to buy the houses from him at a loss – at a much lower price and terms than we could have from the owners. His loss offset his profit from the new houses. Everyone got what he wanted. Learning and practicing the art of negotiation is an essential tool for making money.
